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Moody's Investor Services Inc. Debt Columbia University School of International and Public Affairs Capstone Project Client: Moody’s Investor Services Inc. Debt Intolerance in Latin America By: Amir Safa, Seda Turksever, Juan Pereira, Eduardo Granizo, Nathan Fabius and Quentin Dumont Faculty Advisor: Adjunct Professor Gray Newman May 2, 2017 DISCLAIMER: This study represents the views of the authors and does not represent views of Moody’s Investors Service, Inc. (MIS) or Columbia University. The views expressed herein should be attributed to the authors and not to MIS or Columbia University. MIS provided feedback and observations to the student authors for educational purposes only but is not responsible or liable in any way for the content of the study. Should you wish to contact the authors, please email [email protected], [email protected], [email protected], [email protected], [email protected] and [email protected]. 1 Table of Contents Introduction 3 Literature Review 3 Data Analysis: Latin America 14 Case Study: Mexico 17 Case Study: Chile 20 Case Study: Brazil 23 Case Study: US 26 Appendix 31 2 Introduction Moody’s Latin America Desk asked the Capstone team to examine the presence of debt intolerance in Latin America and to research factors which may help explain its persistence. Some economists describe “debt intolerance” as the inability of emerging market economies to manage levels of overall debt that, under the similar circumstances, would be easily manageable for developed countries.1 For example, during the Great Recession, US total public debt to GDP nearly doubled in a short period of time from 62 percent in 2007 to 100 percent in 2012.2 Yet, the US government did not experience severe economic stress. On the other hand, most - if not all - Latin American economies would not have been able to tolerate such high levels of debt to GDP. Mexico in 1995 with a much lower level of debt to GDP of 34 percent experienced extreme stress and required support from the US government as well as other international financial institutions including the International Monetary Fund.3 While analysts have researched debt intolerance, there is still much debate surrounding this phenomenon. Using the following methods, this report examines factors thought to be most relevant to debt intolerance: (1) providing a literature review on leading publications; (2) recreating a model that regresses credit ratings on a number of indicators of debt intolerance; (3) conducting a sensitivity analysis on Latin American countries on selected indicators of debt intolerance; (4) discussing factors in specific context using three Latin American cases: Mexico, Chile and Brazil, as well as the US to provide a contrasting example of an advanced economy that does not suffer from debt intolerance. Literature Review This section of the report identifies and summarizes these pieces of literature on debt intolerance: 1) “Debt Intolerance” (Reinhart, Rogoff and Savastano 2003) further expanded in the book This Time is Different (Reinhart and Rogoff 2009), which together form the most seminal work on debt intolerance; 2) “A Debt Intolerance Framework Applied to Central America, Panama and the Dominican Republic” (Bannister and Barrot 2011) which provides the most detailed and advanced revisions of the aforementioned works from Reinhart et al.; 3) “The Causes of Sovereign Defaults: Ability to Manage Crises Not Merely Determined by Debt Levels” (Duggar et al. 2010), one of the most relevant publications on sovereign default made available from Moody’s; and 4) “The Institutional Determinants of Debt Intolerance” (Giordano and Tommasino 2011) used in this report to improve existing models by including factors related to institutional strength. The literature review illustrates that there is no systematic approach to understand the mechanics of debt intolerance; however, much of the prominent work uses a “decidedly empirical”4 approach drawing observations from analyses of datasets. There is still work to be done to link up the 3 empirical work with a coherent theoretical framework. (1) “Debt Intolerance” (Reinhart, Rogoff and Savastano 2003); and This Time is Different (Reinhart and Rogoff 2009) In 2003, leading economists Carmen Reinhart, Kenneth Rogoff and Miguel Savastano introduce and coin the term “debt intolerance.” In 2009, Reinhart and Rogoff followed up with the most comprehensive study ever conducted at that time on debt intolerance, culminating in the book This Time is Different. These works are considered the most prominent pieces of literature on this topic. In the paper “Debt Intolerance” the authors argue that “history matters” when considering a country’s ability to take on moderate to high levels of domestic and external debt.5 Specifically, they argue that “safe” external debt-to-GDP thresholds for debt intolerant countries are low and could be as low as 15 percent in some instances.6 The authors conclude that the data overwhelmingly suggests “the thresholds for emerging market economies with high debt intolerance are much lower than those for advanced industrial economies or for those emerging market economies that have never defaulted on their external debt.”7 The thresholds for these countries often depend on the country’s history of default and inflation.8 A history of serial default is linked to a country’s level of vulnerability to a debt crisis as its external debts mount.9 Furthermore, they note debt intolerant countries often experience institutional weaknesses in fiscal structures and financial systems.10 One of their key findings is that debt intolerance can be explained by a small number of factors associated with repayment history, indebtedness level, and history of macroeconomic stability.11 Reinhart, Rogoff and Savastano developed a model in an attempt to quantify debt intolerance for the first time.12 They examine over 100 countries and look specifically at the history of credit events with data going dating back to the 1820s. The model uses a regression analysis to examine the relationship between the Institutional Investor Rating (IIR) on external debt to GNP ratio, default and inflation history. Compiled by the magazine Institutional Investor from a number of global banks and securities firms, the IIR is a metric, which grades countries on a scale of 0 to 100 - with a high score signaling low default probability.13 In their analysis, they examine the extent to which the IIR changes with an additional unit of debt.14 Reinhart and Rogoff significantly expand this initial study in the book This Time is Different. The authors cover eight centuries in providing a quantitative history of financial crises and identifying similarities among them. They expand on their initial argument that “history matters” concluding in the book among the wide range of crises that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers often poses greater systemic risks than it seems during a boom. Among the financial crises analyzed is sovereign debt default, which the authors believe arise for several reasons including: (1) lenders often cannot enforce debt contracts across national borders; (2) shifting political environments including during the time of elections; and (3) a slowdown in financial centers that hit emerging markets that rely heavily on exports and commodities.15 4 (2) A Debt Intolerance Framework Applied to Central America, Panama and the Dominican Republic (Bannister and Barrot 2011) The most important review and revision to the Reinhart, Rogoff and Savastano model can be found in the IMF 2011 paper “Debt Intolerance Framework Applied to Central America, Panama and the Dominican Republic” by Geoffrey J. Bannister and Luis-Diego Barrot. While the authors keep a similar approach of regressing credit ratings on a host of macroeconomic variables and debt repayment history, they have adjusted the Reinhart, Rogoff and Savastano model to overcome some of its shortcomings. Bannister and Barrot sought in their model to reduce endogeneity in debt, inflation and default; take into account changes in the IIR and debt over time; and include domestic debt in addition to external debt to provide a more complete picture of debt intolerance.16 Three of the most important modifications to the Reinhart, Rogoff and Savastano model are discussed here. First, they remove Reinhart, Rogoff and Savastano’s inclusion of IIR rating groups as a variable in the initial equation, which risked explaining IIR ratings by IIR ratings themselves. Second, the authors include time and country fixed effects in their regression. Country fixed effects control for unobserved national features that explain IIR rating but do not move across time. Such unobserved and time-invariant country characteristics for instance include culture or geographic location. Time fixed effects control for unobserved characteristics that influence all countries in the same way but change from period to period. This would typically control for a global financial crisis due to which all countries are equally downgraded, or for years of spectacular global growth leading to a uniform upgrade of all sovereigns. Third, as opposed to Reinhart, Rogoff and Savastano, Banister and Barrot include GDP per capita instead of GDP in their model and expand the number of countries to 120 over 21 years.17 Bannister and Barrot apply the improved model to a sample of non-investment grade Latin American countries to pin down the debt to GDP reduction that would be necessary for each of them to move to improve their sovereign rating.18 For instance, the authors compute how much fiscal consolidation a non-investment grade country should pursue before it can reach investment grade, or how much debt reduction it would take for a highly-speculative grade country to reach speculative. They find that for countries starting with the same credit rating, the fiscal effort they would need to produce to climb to a prime rating can vary considerably.19 This suggests that the market views significant structural political issues surrounding some countries’ ability to borrow.
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